Chapter 14 - Analyzing Financial Statements

Chapter 14

Analyzing Financial Statements

ANSWERS TO QUESTIONS

1.Primary items on the financial statements about which creditors usually are concerned include: (a) income—profit potential of the business, (b) cash flows—ability of the business to generate cash, and (c) assets and debts—financial position.

2.The notes to the financial statements are particularly important to decision makers because they explain, usually in narrative fashion, circumstances and special events that cannot be communicated adequately in the body of the financial statements. The notes call attention to such items as pending problems, contingent liabilities, and circumstances surrounding certain judgments that were made in measuring and reporting. They are useful in interpreting the amounts given in the financial statements and in making projections of the future performance of the business.

3.The primary purpose of comparative financial statements is to provide the user with information on the short-term trends of the various financial factors reported in the financial statements. For example, the trends of such factors as sales, expenses, income, amount of debt, retained earnings, and earnings per share are particularly important in assessing the record of the company in the past and the present. These short-term trends should be used in predicting future performance of the business. Comparative statements usually report only two consecutive periods which often is too short to assess adequately certain trends.

4.Statement users are interested especially in financial summaries covering several years because the long-term trends of the business are revealed. Statement users must make projections of the future performance of the business in their decisions to either invest or disinvest. Long-term financial summaries provide particularly useful information in making these projections. Financial data covering only one or two periods have limited usefulness for this particular type of decision.

The primary limitation of unusually long-term summaries is that early years may not be useful because of changes in the business, industry, and environment.

5.Ratio analysis is a technique for computing and pinpointing certain significant relationships in the financial statements. A ratio or percent expresses a proportionate relationship between two different amounts reported on the financial statements. A ratio is computed by dividing one amount by another amount; the divisor is known as the base amount. For example, the profit margin ratio is computed by dividing net income by net sales. Ratio analysis is particularly useful because it may reveal critical relationships that are not readily apparent from absolute dollar amounts.

6.Component percentages are representations, as ratios or percents, of the relationships between each of the several individual amounts that make up a single total. For example, on the balance sheet the component percentages for assets are computed by dividing the amount of each individual asset by the amount of total assets. The resulting ratios or percentages will sum to 100 percent. Component percentages are useful because they reveal relative relationships that are not readily apparent from absolute dollar amounts.

7.Fundamentally, return on investment is income divided by investment. The two concepts of return on investment are:

(a)Return on equity (net income divided by owners’ investment). This rate reflects the return earned for the owners after deducting the return to the creditors (interest expense is a deduction to derive income).

(b)Return on assets (return on total assets, which includes both owners’ equity and creditors’ equity). This rate reflects the return earned on the total resources employed. The computation is net income plus after-tax interest expense divided by total assets.

Usually both concepts are applied because each serves a somewhat different purpose. Return on equity reflects the viewpoint of the owners because it measures the net return on their investment only. Return on assets reflects the earnings performance of the company on total resources used (i.e., from both owners and creditors).

8.Financial leverage percentage is measured as the difference between the rate of return on equity and the rate of return on assets. This difference is caused only by interest on debt. An excess of the rate of return on equity over the rate of return on assets is due to financial leverage; that is, the company earned a higher rate on total investment than the net-of-tax interest rate on all debt. This advantage accrues to the benefit of the stockholders (i.e., positive leverage).

9.Profit margin is the ratio between net income and net sales. It reflects performance in respect to the control of expenses to net sales but is deficient as a measure of profitability because it does not consider the amount of resources (i.e., investment) used to earn the income amount. Profitability is best measured as the ratio of income to investment.

10.The current ratio is computed by dividing total current assets by total current liabilities. In contrast, the quick ratio is computed by dividing quick assets (i.e., the sum of cash, short-term investments, and accounts receivable) by current liabilities. The current ratio tends to measure liquidity and to indicate the cushion of current assets over current liabilities. In contrast the quick ratio is a much more severe test of current liquidity because the assets used in computing the ratio are cash and those that are very near to cash.

11.A debt/equity ratio reflects the portion of total assets or resources used by a business that was provided by creditors versus owners. In some companies, the amount of debt is approximately 70 percent of the total assets which means that the company is highly leveraged, which is a favorable side of financing by debt. That is, a company earning, say, 20 percent on total assets, while at the same time paying interest of 8 percent on debt, would generate a difference which accrues to the benefit of the stockholders. On the other side, the interest on debt must be paid each period, regardless of whether income was earned, and at the maturity of the debt, the full principal must be paid. In contrast, resources provided by owners are much less risky to the business because dividends do not have to be paid and there is no fixed maturity amount to be paid on a specific date.

12.Market tests are intended to measure the “market worth” per share of stock. Market tests relate some amount to a share of stock (such as EPS or dividends paid per share). Each time the share price changes the measurement changes. The two commonly used market tests are: (a) price/earnings ratio (i.e., market price per share divided by EPS) and (b) dividend yield ratio (i.e., dividends per share divided by the market price per share).

13.The primary limitations associated with using ratios are:

(a) no specification exists (which is generally agreed upon) of how each ratio should be computed and (b) evaluation of the results (i.e., whether a ratio at a given amount is good or bad) is subjective. The latter problem indicates a need to select one or more “standards” against which the computed ratio amount may be compared.

ANSWERS TO MULTIPLE CHOICE

Authors’ Recommended Solution Time

(Time in minutes)

Mini-exercises / Exercises / Problems / Alternate Problems / Cases and
Projects
No. / Time / No. / Time / No. / Time / No. / Time / No. / Time
1 / 5 / 1 / 20 / 1 / 60 / 1 / 60 / 1 / 50
2 / 5 / 2 / 20 / 2 / 45 / 2 / 45 / 2 / 50
3 / 5 / 3 / 20 / 3 / 60 / 3 / 20 / 3 / 60
4 / 5 / 4 / 25 / 4 / 20 / 4 / 60 / 4 / 45
5 / 5 / 5 / 15 / 5 / 60 / 5 / 60 / 5 / 20
6 / 5 / 6 / 20 / 6 / 30 / 6 / 30 / 6 / 30
7 / 5 / 7 / 20 / 7 / 60 / 7 / 30 / 7 / *
8 / 5 / 8 / 20 / 8 / 30
9 / 5 / 9 / 20 / 9 / 20
10 / 5 / 10 / 20 / 10 / 50
11 / 20
12 / 20
13 / 20
14 / 25
15 / 25

* Due to the nature of this project, it is very difficult to estimate the amount of time students will need to complete the assignment. As with any open-ended project, it is possible for students to devote a large amount of time to these assignments. While students often benefit from the extra effort, we find that some become frustrated by the perceived difficulty of the task. You can reduce student frustration and anxiety by making your expectations clear. For example, when our goal is to sharpen research skills, we devote class time to discussing research strategies. When we want the students to focus on a real accounting issue, we offer suggestions about possible companies or industries.

MINI-EXERCISES

M14–1.

Gross Profit ÷ $1,665,000 / = / 44%
Gross Profit / = / $732,600
Revenue / $1,665,000
Cost of Goods Sold / (X)
Gross Profit / $732,600
Cost of Goods Sold / $932,400

M14–2.

2012

Sales / $31,198 *
Cost of Goods Sold / ($9,107)
Gross Profit / $22,091

*Sales 2012:$29,600 x 1.054 = $31,198

Gross Profit %:$22,091 ÷ $31,198 = 70.8%

M14–3.

$183,000 / [($1,100,000 + $1,250,000) ÷ 2] = 15.6%

M14–4.

21% - 6% = 15%

M14–5.

If the average sales volume remains the same, then the cost of goods sold will also remain the same. If the inventory decreases by 25%, the inventory turnover ratio will increase.

M14–6.

Current Assets X

+ Noncurrent Assets $480,000

Total Assets$1,400,000

Current Assets = $920,000

$920,000 ÷ Current Liabilities = 3.5

Current Liabilities = $262,857

M14–7.

Current Ratio / = / Current Assets
Current Liabilities
Quick Ratio / = / Quick Assets
Current Liabilities

By the definitions of current ratio and quick ratio, one can see that the quick ratio must always be less than or equal to the current ratio. We know that a mistake has been made in this case because the quick ratio is greater than the current ratio and that is not possible.

M14–8.

Market Price per Share $228 ÷ Earnings per Share $9.50 = P/E multiplier 24

$9.50 x 1.13 = $10.74

$10.74 x 24 = New Stock Price $257.64

M14–9.

5% = $3.50 ÷ Market Price per Share

$70.00= Market Price per Share

M14–10.

In most circumstances, a change from FIFO to LIFO will cause inventory to decrease and cost of good sold to increase.

Profit Margin / Will decrease
Fixed Asset Turnover / Will not be affected
Current Ratio / Will decrease
Quick Ratio / Will not be affected

EXERCISES

E14–1.

1.Car manufacturer (high inventory; high property & equipment; lower inventory turnover)

2.Wholesale candy company (high inventory turnover)

3.Retail fur store (high gross profit; high inventory)

4.Advertising agency (low inventory; absence of gross profit)

E14–2.

1.Meat packer (high inventory turnover)

2.Travel agency (no gross profit or inventory; high receivables)

3.Hotel (high property & equipment; no gross profit or inventory)

4.Drug company (high gross profit, low inventory turnover)

E14–3.

1.Cable T.V. Company (no gross profit; high property & equipment)

2.Accounting firm (high receivables; no gross profit)

3.Retail jewelry store (high inventory; high gross profit)

4.Grocery store (high inventory turnover)

E14–4.

1. Restaurant (high inventory turnover; high property & equipment)

2. Full-line department store (high cost of inventory; high gross profit)

Automobile dealer (high cost of inventory; low property & equipment)
Wholesale fish company (high inventory turnover; lower gross profit)

E14–5.

1. / A / Profit margin
2. / H / Inventory turnover ratio
3. / B / Average days to collect
4. / L / Dividend yield ratio
5. / C / Return on equity
6. / G / Current ratio
7. / K / Debt/equity ratio
8. / M / Price/earnings ratio
9. / E / Financial leverage percentage
10. / I / Receivable turnover ratio
11. / J / Average days’ supply in inventory
12. / D / Earnings per share
13. / N / Return on assets
14. / F / Quick ratio
15. / Q / Times interest earned
16. / O / Cash coverage ratio
17. / P / Fixed asset turnover ratio

E14–6.

Consolidated Statements of Earnings
(In millions, except per share and percentage data) / January 30, / % / February 1, / % / February 2, / %
Fiscal years ended on / 2009 / Sales / 2008 / Sales / 2007 / Sales
Net sales / 100.00 / % / 100.00 / % / 100.00 / %
Cost of sales / 65.79 / 65.36 / 65.48
Gross margin / 34.21 / 34.64 / 34.52
Expenses:
Selling, general and administrative / 22.96 / 21.78 / 20.75
Store opening costs / 0.21 / 0.29 / 0.31
Depreciation / 3.19 / 2.83 / 2.48
Interest - net / 0.58 / 0.40 / 0.33
Total expenses / 26.94 / 25.30 / 23.87
Pre-tax earnings / 7.27 / 9.34 / 10.65
Income tax provision / 2.72 / 3.52 / 4.03
Net earnings / 4.55 / % / 5.82 / % / 6.62 / %

There is a steady decline in net earnings as a percent of sales which gross margin is fairly stable. The decline in profitability appears to be related to cost control with expenses increasing as a percent of sales. Management should focus on reducing selling, general and administrative costs.

E14–7.

Current Assets
(1) /
Current Liabilities
(2) / Current
Ratio
(1 ÷ 2)
Start / $54,000 / ($54,000 ÷ 1.5) / $36,000 / 1.50
Transaction (1) / Inventory / + 7,000 / Accts. Pay. / + 7,000
Subtotal / 61,000 / 43,000 / 1.42
Transaction (2)* / Cash / – 3,000
$58,000 / $43,000 / 1.35

*Debt and truck are noncurrent items.

E14–8.

Effect on Current Ratio

1. / Increase, assuming that cash was collected from sale
2. / Will decrease
3. / Will decrease
4. / Will increase

E14–9.

Turnover:

Accounts receivable $68,828* ÷ [($6,629 + $5,725) ÷ 2] / = / 11.1
Inventory ($76,476 x .48) ÷ [($6,819 + $6,291) ÷ 2] / = / 5.6
*$76,476 x 90% = $68,828

Days:

Accounts receivable (365 days ÷ 11.1) / = / 32.9
Inventory (365 days ÷ 5.6) / = / 65.2

E14–10.

Rate of return on equity $4,341 ÷ ($13,930 – $2,570) / = / 38.2 / %
Rate of return on assets
[$4,341 + ($2,570 x .08 x .7)] ÷ $13,930 / = / 32.2 / %
Financial leverage percentage (positive) / = / 6.0 / %

E14–11.

Current Assets
(1) /
Current Liabilities
(2) / Current
Ratio
(1 ÷ 2)
Start / $100,000 / ($100,000 ÷ 1.5) / $66,667 / 1.50
Transaction (1) / Cash / –6,000 / Accts. pay. / –6,000
Subtotal / 94,000 / 60,667 / 1.55
Transaction (2) / Cash / –11,000
83,000 / 60,667 / 1.37
Transaction (3) / No impact
83,000 / 60,667 / 1.37
Transaction (4) / Cash / –28,000 / Dividends pay. / –28,000
$ 55,000 / $32,667 / 1.68

E14–12.

Cost of Goods Sold=4.6 x $1,456,414,000

Cost of Goods Sold =$6,699,504,400

Net Sales=7.5 x $1,218,874,000

Net Sales= $9,141,555,000

Less: CGS= 6,699,504,400

Gross profit= $2,442,050,600

E14–13.

Turnover:

Accounts receivable $500,000* ÷ [($45,000 + $60,000) ÷ 2] / = / 9.5
Inventory ($1,000,000 x .5) ÷ [($70,000 + $25,000) ÷ 2] / = / 10.5
*$1,000,000 x 50% = $500,000

Days:

Accounts receivable (365 days ÷ 9.5) / = / 38.4
Inventory (365 days ÷ 10.5) / = / 34.8

E14–14.

Current Assets
(1) /
Current Liabilities
(2) / Current
Ratio
(1 ÷ 2)
Start / $410,000 / ($410,000 ÷ 2) / $205,000 / 2.00
Transaction (1) / A/R* / +11,000
Subtotal / 421,000 / 205,000 / 2.05
Transaction (2) / Dividends pay. / +50,000
421,000 / 255,000 / 1.65
Transaction (3) / Cash Prepaid / -12,000
+12,000
421,000 / 255,000 / 1.65
Transaction (4) / Cash / -50,000 / Dividends pay. / -50,000
371,000 / 205,000 / 1.81
Transaction (5) / Cash / +11,000
-11,000
A/R
371,000 / 205,000 / 1.81
Transaction (6) / ST Lia. / +30,000
371,000 / 235,000 / 1.58

*We assume that the periodic inventory system is used and, therefore, there is no impact on inventory. Some students will try to try to reduce inventory as part of this transaction.

E14–15.

Current Ratio / $811,805
$403,038 / = / 2.01
Inventory Turnover / $1,515,815 / = / 7.05
[($231,741 + $198,000) ÷ 2]
Account Receivable Turnover / $2,224,140 * / = / 5.57
[($408,870 + $389,905) ÷ 2]
* $3,706,900 x 60% = $2,224,140

PROBLEMS

P14–1.

Company A has a high level of liquidity as shown by the current ratio but the low quick ratio indicates that much of the liquidity is tied up in inventory.
The low inventory turnover is another indication of an excessive amount of inventory. Analysts would be concerned about whether the inventory could be quickly converted to cash.
In addition to liquidity concerns, Company A shows a high debt/equity ratio.
Company A does not seem to have good growth opportunities. The market has valued Company A at a low price/earnings multiple.

P14–2.

Company A is either extremely efficient at inventory management or it does not carry enough inventory to support its operations. The low current ratio (in combination with an average quick ratio) and the high inventory turnover give an indication of low levels of inventory.
Company A appears to have the ability to borrow additional funds given its low debt/equity ratio.
Company A seems to pay low dividends and has a high price/earnings multiple. These ratios would suggest good growth opportunities.

P14–3.

Commerce Bank / C. 15
Duke Energy / F. 13
Ford / D. Not applicable
Home Depot / B. 12
Motorola / G. 99
Starbucks / A. 33
Pepsi / E. 20
Continental Airlines / H. 8

P14–4.

JCPenney is the stronger company and probably the better investment. JCPenney has a higher gross profit margin, which means that they make more gross profit on each dollar of sales than does Sears. This is very significant since the two companies are in the same business, and operate in the same way. The higher gross profit for JCPenney is also reflected in its higher profit margin and stronger return on assets and return on equity. The JCPenney capital structure includes more debt which gives the company a higher degree of financial leverage. Their investors receive a higher return on equity but there is additional risk. JCPenney is paying dividends while Sears is not. The P/E ratio for Sears is higher than JCPenney suggesting that the market sees better growth prospects for Sears. While EPS for Sears is higher, the stock costs more than twice as much as the stock for JCPenney.
P14–5.

Req. 1

Ratio / Price Company / Waterhouse Company
Tests of profitability:
1. / Return on equity / $45,000 ÷ $238,000 = 18.91% / $93,000 ÷ $689,000 = 13.50%
2. / Return on assets / [$45,000 + ($65,000 x 10% x.70)]
÷ $402,000 = 12.33% / [$93,000 + ($60,000 x 10% x .70)]
÷ $798,000 = 12.18%
3. / Financial leverage percentage / 18.91% – 12.33% = 6.58% / 13.50% – 12.18% = 1.32%
4. / Earnings per share / $45,000 ÷ 14,800 sh. = $3.04 / $93,000 ÷ 51,200 sh. = $1.82
5. / Profit margin / $45,000 ÷ $447,000 = 10.07% / $93,000 ÷ $802,000 = 11.60%
6. / Fixed asset turnover / $447,000 ÷ $140,000 = 3.19 / $802,000 ÷ $401,000 = 2.00
Tests of liquidity:
7. / Cash ratio / $41,000 ÷ $99,000 = .41 / $21,000 ÷ $49,000 = .43
8. / Current ratio / $178,000 ÷ $99,000 = 1.80 / $92,000 ÷ $49,000 = 1.88
9. / Quick ratio / $79,000 ÷ $99,000 = .80 / $52,000 ÷ $49,000 = 1.06
10. / Receivable turnover / $149,000 ÷
[($38,000 + $18,000) ÷ 2] = 5.32 / $267,333 ÷ [($31,000 + $38,000) ÷ 2]
= 7.75
11. / Inventory turnover / $241,000 ÷
[($99,000 + $94,000) ÷ 2] = 2.50 / $398,000 ÷ [($40,000 + $44,000) ÷ 2]
= 9.48
Solvency and equity position:
12. / Debt/equity ratio / $164,000 ÷ $238,000 = .69 / $109,000 ÷ $689,000 = .16
Market tests:
13. / Price/earnings ratio / $17 ÷ $3.04 = 5.59 / $15 ÷ $1.82 = 8.24
14. / Dividend yield ratio / ($33,000 ÷ 14,800 shares) ÷
$17 = 13.12% / ($148,000 ÷ 51,200 shares) ÷ $15
= 19.27%

Req. 2

Recommended choice: Price Company

Basis for recommendation:

The reported information for Price Company is audited; therefore, it has more credibility.
Profitability in the future has a higher probability for Price Company because the return on equity is better although return on assets is about the same. The resulting leverage advantage occurs because of the use of debt. Price Company obtains more of its total resources by borrowing.

P14–5. (continued)

Req. 2 (continued)

Price Company is taking better advantage of this leverage. The advantageous position of Price Company also is reflected in EPS. Price Company has a profit margin of 10% (compared with the better 11.6% profit margin of Waterhouse Company). Price Company earned net income of $45,000 while using total investment of only $402,000. Waterhouse Company earned net income of $93,000 (twice as much) while using total investment $798,000 (also twice as much), but Price Company obtained a much higher percent of its total investment through debt (thus, a much better leverage factor, and a much higher return on owners’ equity.

3.Waterhouse Company has a better liquidity position measured in terms of the current ratio and the quick ratio. Waterhouse Company is in a better position in respect to credit and collections as shown by the receivable turnover ratio. Also, Price Company reflects a significantly lower (unfavorable) inventory turnover. This difference, in view of sales revenue, suggests overstocking by Price.

4.The market tests favor Waterhouse Company but the company declared and paid a dividend in excess of 2012 profits. This pattern cannot be continued. This payout should cause concern because Waterhouse Company is low on cash.

Constraint—The above analysis is based on only one year which poses a problem of evaluation. Selected detailed data for the prior year should be analyzed in a similar manner. A five- to ten-year summary of selected values also would be quite useful. Other particularly important information should be evaluated, such as the characteristics of the company, the industry, economic conditions, and the quality of the management.

P14–6.

Req. 1

Increase (Decrease)
2012 over 2011
Income Statement / 2012 / 2011 / Amount / Percent
Sales revenue / $190,0001 / $167,000 / $ 23,000 / 13.77
Cost of goods sold / 112,000 / 100,000 / 12,000 / 12
Gross profit / 78,000 / 67,000 / 11,000 / 16.42
Operating expenses and interest expense / 56,000 / 53,000 / 3,000 / 5.66
Pretax income / 22,000 / 14,000 / 8,000 / 57.14
Income tax / 8,000 / 4,000 / 4,000 / 100
Net income / 14,000 / 10,000 / $ 4,000 / 40
Balance Sheet
Cash / $4,000 / $7,000 / $ -3,000 / -42.86
Accounts receivable (net) / 14,000 / 18,000 / -4,000 / -22.22
Inventory / 40,000 / 34,000 / 6,000 / 17.65
Operational assets (net) / 45,000 / 38,000 / 7,000 / 18.42
103,000 / 97,000 / $ 6,000 / 6.19
Current liabilities (no interest) / $16,000 / $17,000 / $ -1,000 / -5.88
Long-term liabilities (10% interest) / 45,000 / 45,000 / 0 / 0
Common stock (par $5) / 30,000 / 30,000 / 0 / 0
Retained earnings2 / 12,000 / 5,000 / 7,000 / 140
103,000 / 97,000 / $ 6,000 / 6.19
1One-third was credit sales. 2 During 2012, cash dividends amounting to $3,000 were declared and paid.
Req. 2
Working capital change / 0

P14–7.